Friday, July 29, 2011

Noam Chomsky is America’s leading advocate of libertarian socialism, though his political and economic thought draws on diverse traditions and the thinking of intellectuals such as Wilhelm von Humboldt, Mikhail Bakunin, John Dewey, Bertrand Russell, and Rudolf Rocker. Chomsky’s conception of “socialism” is anarcho-syndicalism, a system where production and production institutions would be worker-owned, democratically self-managed enterprises. Other notable syndicalists were Rudolf Rocker and the young Bertrand Russell. Syndicalism has been a major non-Marxist socialist tradition. Chomsky gives his views on the meaning of socialism in the video below.

I would argue, however, that either (1) radical progressive liberalism or (2) social democracy of the Scandinavian type has just as legitimate a claim to the name “democratic socialism.” Of course, one of the severe failings of progressive liberalism and social democracy is the inability to free themselves from neoclassical economics and the power of the private capitalist institutions. When Chomsky quotes John Dewey and complains that “politics is the shadow cast on society by big business,” he is no doubt right. The excesses of modern multinational corporations and big business are an outrage on many levels.

But, while worker-run enterprises might very well provide a superior form of business organisation, it seems to me that in some respects they would still face much the same problems as private capitalists: if the decision-making done in a worker-managed enterprise/cooperative is done by its workers, and there are thousands or hundreds of thousands of such cooperatives making de-centralized decision-making on production (even if this involves a democratic process involving many people in each individual enterprise), then you would have decisions on investment and production made in a decentralised manner that is essentially private. If the economy uses money and has some types of financial assets as a store of value, you have exactly the same problems that exist now. The people involved would still be making decisions under subjective expectations and fundamental uncertainty, and investment would, most probably, be subject to fluctuation. Say’s law would not hold in a syndicalist economy. In such an economy, there would still be failures of aggregate demand, and some democratically-accountable institution would be required to intervene at the macro-level to overcome such macro-problems. That institution would, I contend, end up being a de facto government, and would probably also accrue other responsibilities such as implementing democratic decisions on foreign policy, defence, monetary policy, science policy, education standards, and so on. I suspect that a syndicalist society would evolve into a state-based system not that much different from the most radical forms of progressive liberalism or social democracy.

This is a recording of Ludwig von Mises (1881–1973) speaking on May 17, 1962. Mises discusses the history of capitalism and wages, and he was speaking at the height of the era of classical Keynesianism. Curiously, at the end, he proclaims that good profits and high wages “go hand-in-hand.” That was so in the Golden Age of Capitalism (1945-1973), but, with the advent of the new neoclassical economics in the 1970s and 1980s, real wages have stagnated or performed poorly in capitalist country after country.

Thursday, July 28, 2011

Post Keynesians reject the gross substitution axiom, an implicit assumption made by both Austrians and neoclassicals. In brief, money and financial assets have zero or near zero elasticity of substitution with producible commodities.

The operative concept is demand for liquidity. The most liquid asset is money, and, in varying degrees of liquidity, there follow various types of financial assets, which are nonproducible and held as a store of value:

“If the gross substitution axiom was universally applicable, however, any new savings that would increase the demand for nonproducibles would increase the price of nonproducibles (whose production supply curve is, by definition, perfectly inelastic). The resulting relative price rise in nonproducibles vis-a-vis producibles would, under the gross substitution axiom, induce savers to increase their demand for reproducible durables as a substitute for nonproducibles in their wealth holdings. Consequently nonproducibles could not be ultimate resting places for savings as they spilled over into a demand for producible goods ... Samuelson’s assumption that all demand curves are based on an ubiquitous gross substitution axiom implies that everything is a substitute for everything else. In Samuelson’s foundation for economic analysis, therefore, producibles must be good gross substitutes for any existing nonproducible liquid assets (including money) when the latter are used as stores of savings. Accordingly, Samuelson’s Foundation of Economic Analysis denies the logical possibility of involuntary unemployment as long as all prices are perfectly flexible.” (Davidson 2006: 189).

Neoclassical synthesis Keynesians and Post Keynesians part company on precisely this point: the gross substitution axiom is false, and even if all wages and prices were perfectly flexible, you would still have involuntary unemployment, for these reasons:

(1) with no truth in the gross substitution axiom, demand for liquid financial assets as a store of value, even when it raises the relative prices of nonproducible financial assets in relation to producible commodities will not necessarily spill over into demand for the latter;

(2) Say’s law does not hold in any economy where we face uncertainty, subjective expectations, and money and financial assets with a store of value function;

(3) Liquidity preference and the desire for increased liquidity apply not just to individuals but also to banks and other business institutions; indeed, in modern capitalist economies it is the liquidity preferences of banks that are particularly important.

(5) L. Randall Wray on the Debt Ceiling, 14 July 2011.
This is a short interview with Randall Wray on Russia Today, with some curious references to Ron Paul, the Fed’s toxic assets, and the limitations of monetary policy.

Tuesday, July 26, 2011

With the Republicans basically preparing to destroy the US economy over the debt ceiling, we might wonder what severe austerity means in human terms. For this, we can go back to 2009 and review the wonderful “achievements” of austerity in Latvia, as displayed in the video below, where an unusually extreme form of it was imposed on the population.

This is an interesting interview with James Galbraith, and covers quite a few issues. With the debt ceiling issue now becoming a looming disaster if Republicans have their way, Galbraith alerts us to the fact that Obama’s Democratic party and especially its leadership have long since ceased to be progressive on economics.

An important point is that the US financial sector will also suffer badly if the debt ceiling is not raised, and they will probably pressure the Republicans to make some deal: will the Republicans bow to the same powerful interests who fund them and the Democrats?

James Jerome Hill (1838–1916), the Canadian-American railroad entrepreneur, was the businessman behind America’s Great Northern Railway (which before September 18, 1889 was called the Minneapolis and St. Cloud Railway), a very successful private 19th-century railway that ran from Saint Paul (Minnesota) to Seattle (Washington state), which was completed in January 1893.

The level of government involvement in America’s 19th-century railroads is, of course, well known: the first transcontinental railroad (the “Pacific Railroad” or “Overland Route”) was constructed between 1863 and 1869 and involved massive government support with the issuing of 30-year U.S. government bonds to fund its construction and large grants of government-owned land.

James J. Hill is often invoked as a hero by apologists for extreme laissez faire, because his railway was allegedly built completely privately, without any government subsidies or land grants. Unfortunately, there some inconvenient facts the free market ideologues leave out when they discuss Hill and the Great Northern Railway:

(1) Hill acquired a pre-existing railway called the Saint Paul and Pacific Railroad (which was originally charted as the “Minnesota and Pacific Railroad” in 1857) as the starting basis for his Great Northern Railway. The Saint Paul and Pacific Railroad existed because of massive government support:

“In 1857, the territorial legislature of the state of Minnesota issued a charter to the Minnesota and Pacific Railroad to build a standard gauge railway from Stillwater in the east to St. Paul in the west .... The railroad received a grant of 2,460,000 acres (1,000,000 ha) of land from the territorial legislature. This was the seventh largest land grant of the 75 given to railroads nationwide between 1850 and 1871. Construction began in the autumn of 1857, and in 1856 the state backed a $5 million bond issue to support the new rail system. But speculators manipulated the nascent railroad’s profits, overcharged it for supplies, and sold off some of its assets. It went bankrupt in 1860, and the new state legislature purchased all of its assets for a mere $1,000. … In 1862, the state legislature reorganized the bankrupt railroad as the St. Paul and Pacific Railroad.
....
But James J. Hill, who ran steamboats on the Red River, knew that the SP&P owned very valuable land grants and saw the potential of the railroad. Hill convinced John S. Kennedy (a New York City banker who had represented the Dutch bondholders), Norman Kittson (Hill’s friend and a wealthy fur trader), Donald Smith (a Montreal banker and executive with the Hudson’s Bay Company), and George Stephen (Smith’s cousin and a wealthy railroad executive) to invest $5.5 million in purchasing the railroad. On March 13, 1878, the road's creditors formally signed an agreement transferring their bonds and control of the railroad to Hill's investment group. On September 18, 1889, Hill changed the name of the Minneapolis and St. Cloud Railway (a railroad which existed primarily on paper, but which held very extensive land grants throughout the Midwest and Pacific Northwest) to the Great Northern Railway. On February 1, 1890, he transferred ownership of the StPM&M, Montana Central Railway, and other rail systems he owned to the Great Northern.”

(2) Hill benefited from government negotiations with Native Americans to obtain the right to build his railway on their land:

“The Great Northern had to stop construction in 1886 to wait for the government’s negotiations for Indian lands. The 1887 agreement over the Sweetgrass Hills gave the Great Northern Railway a 75-foot right-of-way over the Rocky mountains and through Western Montana-plus permission to use all the stone and lumber it needed for construction.” (Holmes, Dailey, and Walter 2008: 175).

Lloyd J. Mercer summarises how Hill’s Great Northern System relied on the acquisition of previous state-subsidised railways with land grants:

“The Great Northern System was an outgrowth of the St. Paul, Minneapolis and Manitoba Railroad, which was formed May 23, 1879, considerably after the end of the land grant era. The St. Paul, Minneapolis and Manitoba was initially formed out of the foreclosed St. Paul and Pacific railroad, which had come into possession of a federal land grant created by an act of March 3, 1857. The unsold portion of that old grant passed to the new company and became the major part of the land grant of the Great Northern System. In 1880–1881 the St. Paul, Minneapolis and Manitoba acquired the charter of the Minneapolis and St. Cloud Railway Company, to which was attached a land grant from the State of Minnesota in the amount of 10 sections per mile. This grant formed the remainder of the land grant of the Great Northern System, which became the beneficiary of efforts to subsidize predecessor railroads that were, unlike the Great Northern, truly pioneer effects.” (Mercer 1982: 59–60).

Mercer (1982: 148) also concludes the acceleration of the “construction and operation [sc. of America’s railways] through subsidization made a positive contribution to nineteenth-century economic growth in the United States. On efficiency grounds government intervention in the timing of the railroad building decision was rational.” James J. Hill was in fact a beneficiary of that government intervention by his acquisition of earlier railways.

Sunday, July 24, 2011

Rothbard has a curious attitude to monopoly and cartel prices. Rothbard admits the possibility of monopolies and cartels arising on the completely free market, and defends their existence in these circumstances:

“So far we have established that there is nothing ‘wrong’ with monopoly price, either when instituted by one firm or by cartel; that, in fact, whatever price the free market (unhampered by violence or the threat of violence) establishes will be the ‘best’ price.” (Rothbard 2009: 661).

Yet, since a monopoly or cartel will be a price setter, it is nonsense to talk about the monopoly price being the price the “free market establishes.” The charge that Rothbard exhibits a double standard on monopoly was also made by L. E. Hill (1963).

Rothbard’s views must be set within the framework of broader Austrian ideas on monopoly:

“Since Rothbard’s economic theories are generally within the Austrian economic tradition, it might be useful to compare his position on monopoly with those of Ludwig von Mises and Israel M. Kirzner. Mises held that monopoly could exist in a free market whenever the entire supply of a commodity was controlled by one seller or a group of sellers acting in concert. Such a situation was not necessarily harmful unless the demand curve for the commodity was inelastic. Then, according to Mises, the monopolist would have a perverse incentive to restrict production and create a monopoly price, and that price would be ‘an infringement of the supremacy of the consumers and the democracy of market.’ Kirzner has suggested that the monopoly ownership of some resource could have ‘harmful effects’ since it would create an incentive on the part of the resource owner to not employ the resource to ‘the fullest extent compatible with the pattern of consumer tastes’ in the market.” (Armentano 1988: 7).

Rothbard rejects the definition of monopoly as the control of the supply of a commodity, and thinks that there is no distinction between competitive and monopoly prices on a completely free market.

On pp. 662ff. of Man, Economy, and State, Rothbard engages in a tortuous and utterly unconvincing attempt to deny any difference between a small producer in a competitive market and a larger corporation with a large share of production. Rothbard’s eventual definition of monopoly only as a right of exclusive production granted by the state to some entity is a piece of legerdemain that allows him to argue that “monopoly can never arise on a free market” (Rothbard 2009: 670).

Moreover, Rothbard’s view is inconsistent, since elsewhere his view is that free markets are superior precisely because consumers set prices:

“On the free market, consumers can dictate the pricing and thereby assure the best allocation of productive resources to supply their wants. In a government enterprise, this cannot be done.” (Rothbard 2009: 1261).

But, if on the unhampered market, cartels, oligopolies and monopolies could develop in product markets, and the prices of commodities were then set by price setters/price administrators, and not by the dynamics of supply and demand curves, then it is obvious that consumers are not dictating pricing. According to Rothbard’s argument here, unhampered free markets would not assure the best allocation of productive resources, with cartel and monopoly prices being present.

Of course, anyone who has read the specialist literature from modern marketing departments, which studies the empirical reality of how prices are set, knows that business prefers stable prices to the instability of fluctuating ones and disastrous price wars. In the real world, modern corporations are often prices setter, not price takers. Price setting has benefits overlooked by libertarian and free market ideologues.

There is another criticism that can be made. Rothbard thought free markets have a tendency to equilibrium, if not to reach an equilibrium state:

“Rothbard presumed that in individual markets, the law of one price dominated, and that market clearing happened rapidly and smoothly (124). Just as in conventional neoclassical economics, general equilibrium, the evenly rotating economy (ERE), was the direction in which the economy was headed. The pervasiveness of change made it unlikely that an economy would ever achieve the ERE, but nevertheless, like a dog chasing a mechanical rabbit, it at least could explain the direction of change (274). Although Rothbard warned against taking equilibrium too seriously given the world of constant change in which we live (277), it was nevertheless his underlying assumption that markets adjust quickly to new equilibrium positions. Indeed, his justification for the basic efficiency of markets was that ‘entrepreneurs will be very quick to leave the losing industry’ (466) when mistakes are made.” (Vaughn 1994: 97).

One of the elements that supposedly cause the basic efficiency of markets is the flexibility of prices. But with Rothbard’s recognition that cartels and monopolies could arise on a free market and set prices, there is actually less likelihood of price flexibility and market clearing.

Rothbard does not explain how an anarcho-capitalist society would deal with coercive monopolies arising on free markets.

A perfect example of how a competitive market in an anarcho-capitalist system could collapse into a coercive monopoly is protection and policing. Private protection firms would in fact have an incentive to victimise potential customers to increase market share. Violence of the type that already happens between private mafia groups might occur. A natural monopoly would probably develop as the most powerful firm drove its competitors out of business (or a cartel might become dominant), and one would be left with a de facto state, the very thing anarcho-capitalism sought to abolish.

Wednesday, July 20, 2011

If we want to understand why Hayekian versions of the Austrian business cycle theory (ABCT) fail, the Sraffa-Hayek debate is the place to start. I will start a bibliography here and update it.

The exchange itself began with Sraffa’s (1932a) review of Hayek’s Prices and Production (London, 1931), then Hayek’s (1932) reply, and Sraffa’s (1932b) response.

Lachmann (1994: 154) is an Austrian attempt to answer Sraffa on the multiple natural rates issue, but Murphy (in “Multiple Interest Rates and Austrian Business Cycle Theory”) has essentially admitted defeat on the issue of the existence of an unique natural rate of interest.

Many other Austrians, however, continue to use the unique natural rate concept in discussions of ABCT, and this is one of the major flaws in the theory.

Lawlor, M. S. 1994. “The Own-Rates Framework as an Interpretation of the General Theory: A Suggestion for Complicating the Keynesian Theory of Money,” in J. B. Davis (ed.), The State of Interpretation of Keynes, Kluwer Academic, Boston and London. 39–90.

Murphy, Robert P. 2003. Unanticipated Intertemporal Change in Theories of Interest, PhD dissert., Department of Economics, New York University.

Tuesday, July 19, 2011

On the Sraffa versus Hayek debate, Murphy has some valuable remarks. When Sraffa demonstrated that outside of equilibrium there is no single natural rate of interest in a barter or money-using economy, Hayek never really addressed this problem for his trade cycle theory.

Murphy points out the following:

“In his brief remarks, Hayek certainly did not fully reconcile his analysis of the trade cycle with the possibility of multiple own-rates of interest. Moreover, Hayek never did so later in his career. His Pure Theory of Capital (1975 [1941]) explicitly avoided monetary complications, and he never returned to the matter. Unfortunately, Hayek’s successors have made no progress on this issue, and in fact, have muddled the discussion. As I will show in the case of Ludwig Lachmann—the most prolific Austrian writer on the Sraffa-Hayek dispute over own-rates of interest—modern Austrians not only have failed to resolve the problem raised by Sraffa, but in fact no longer even recognize it.

Austrian expositions of their trade cycle theory never incorporated the points raised during the Sraffa-Hayek debate. Despite several editions, Mises’ magnum opus (1998 [1949]) continued to talk of “the” originary rate of interest, corresponding to the uniform premium placed on present versus future goods. The other definitive Austrian treatise, Murray Rothbard’s (2004 [1962]) Man, Economy, and State, also treats the possibility of different commodity rates of interest as a disequilibrium phenomenon that would be eliminated through entrepreneurship. To my knowledge, the only Austrian to specifically elaborate on Hayekian cycle theory vis-à-vis Sraffa’s challenge is Ludwig Lachmann.”
(Murphy, “Multiple Interest Rates and Austrian Business Cycle Theory,” pp. 11–12).

“Lachmann’s demonstration—that once we pick a numéraire, entrepreneurship will tend to ensure that the rate of return must be equal no matter the commodity in which we invest—does not establish what Lachmann thinks it does. The rate of return (in intertemporal equilibrium) on all commodities must indeed be equal once we define a numéraire, but there is no reason to suppose that those rates will be equal regardless of the numéraire. As such, there is still no way to examine a barter economy, even one in intertemporal equilibrium, and point to “the” real rate of interest.”
(Murphy, “Multiple Interest Rates and Austrian Business Cycle Theory,” pp. 14).

On p. 14, Murphy states what I have already argued elsewhere: that Mises’s originary interest rate (a pure time preference theory of interest) becomes the “natural” rate imagined in Misesian versions of the trade cycle theory.

On pp. 19–23 in a simple model, Murphy provides his attempt to show how an inflationary increase in the money supply can cause “people in earlier periods to consume too much,” and his analysis in the (simple) model is fine, as far as it goes. But even he admits this is “not really an illustration of the Misesian trade cycle theory,” because his model does not “really exhibit malinvestments in longer production processes.” Murphy leaves the creation of such a model for his future research.

Murphy’s conclusions are significant:

“In summary, Austrians should familiarize themselves with the construct of a dynamic equilibrium, in which spot prices and other data can evolve over time, but where entrepreneurs fully anticipate such changes and squeeze out all pure profit opportunities. In this setting, there is no such thing as an objective real or natural rate of interest, so the Austrians cannot cling to their prescription that the banks ought to set the market rate to “the” natural rate. However, as our last scenario above hoped to convey, it still is true that an intertemporal, dynamic equilibrium can be disturbed if commercial banks inject new money into the credit markets. If a Misesian boom-bust cycle ensues, the reason is not that the banks charged a money right below “the” natural rate, because there is no such thing. Yet the basic Misesian analysis still holds true, that the bankers have suddenly augmented the purchasing power of one segment of the population, which not only redistributes real wealth but also leads to distorted money prices and more mistakes than otherwise would have occurred.”
(Robert P. Murphy, “Multiple Interest Rates and Austrian Business Cycle Theory,” p. 23).

So Murphy has dispensed with the Wicksellian natural interest rate concept, but still thinks a Misesian boom-bust cycle can occur. But this of course raises the following questions:

(1) Fractional reserve banking has always redistributed “real wealth” to those who first receive loans: usually it goes to capitalists who increase investment, employment and output to make us wealthier. Why is this a bad thing? Even loans extended under a pure gold standard would redistribute “real wealth” to the first holders of the money: the issue is whether real resources are available.

(2) What happens when new fiduciary media or fiat money can simply use idle resources, such as unemployed labour, unused stocks of raw materials, idle capital goods and other factor inputs?

(3) What happens when fiduciary media or fiat money can simply be used to import the relevant factor inputs through international trade, and these factor inputs are not scarce?

(4) Even when domestic factor inputs become scarce and an economy runs at full employment, and inflationary pressures build up, this is exactly the time when Keynesian macroeconomic policy has measures to deal with the boom: a contraction in demand to free up real resources for a further growth cycle.

At any rate, I am impressed with this paper by Murphy. Though I have not become a convert to ABCT, without any doubt Murphy’s paper is the best attempt to improve and build on the Austrian trade cycle theory I have seen in a long time.

Friday, July 15, 2011

Russ Roberts drags up the mistaken prediction that Paul Samuelson made during World War II and complains:

“I don’t know what private aggregate demand means, or the phrase “pent-up” demand. The usual way that Keynesians explain the post-war expansion despite the huge cut in government spending is to say, well of course the economy boomed, there was a lot of pent-up demand. What does that mean? There is always pent-up demand in the sense there is a stuff I wish I could have but can’t. But the standard story is that people couldn’t buy washing machines or cars during the war–they were rationed or simply unavailable or unaffordable. So when the war ended, and rationing and price controls ended, people were eager to buy these things. But the reason these consumer goods were rationed or unavailable is because all the steel went into the tanks and planes during the war. So when the war ended, there was steel available to the private sector. That’s why cutting government activity can stimulate the private sector.”

But American consumers could not spend the money on consumption during the war, owing to shortages, rationing and the fall in production of consumer goods. Unless you seriously believe that the desire to consume — to satisfy your subjective utility preferences by buying commodities — does not rise with income, then the meaning of “pent up” should be obvious: it means the desire to purchase consumer goods but being unable to buy them, even though you have the money.

When the war ended and the wartime command economy was dismantled, resources were freed up for reconversion to a peacetime consumer economy, and there was a totally atypical downturn in 1945 were GDP fell by 12.5% between February and October:

“The decline in government spending at the end of World War II led to an enormous drop in gross domestic product making this technically a recession. This was the result of demobilization and the shift from a wartime to peacetime economy. The post-war years were unusual in a number of ways (unemployment was never high) and this era may be considered a ‘sui generis end-of-the-war recession’.” http://en.wikipedia.org/wiki/List_of_recessions_in_the_United_States

Samuelson feared that there might be a return to long-term depression after this conversion: he was wrong. There was the massive surge in consumption after 1945 using accumulated savings, and income rose even more after the 1945 tax cut of $6 billion, passed in November. The post-war growth to 1948 was an entirely predictable development consistent with Keynesian economics.

In 1943 — the same year Samuelson got it wrong — Keynes was giving a lecture at the Federal Reserve and was asked by Abba Lerner about the possible economic problems of the post-war period. Keynes’s reply is significant:

“Keynes harshly rejected the risk of post-war stagnation, holding that because of Social security there would be a large reduction in private saving and so that would be no problem.”
D. C. Colander and H. Landreth (eds), The Coming of Keynesianism to America, E. Elgar, Cheltenham. 1996. p. 202.

In other words, Americans now had the security of welfare programs that allowed them to free up more of their income in spending.

What kind of analysis of the post-war boom ignores what Keynes — the founder of Keynesian economics — thought about this question? Samuelson was simply wrong; Keynes was right.

Another problem for Austrians is this: there was a very sharp rise in government spending from 1948 to a 1953? Why?

The second post-WWII recession extended from November 1948 to October 1949. Truman’s budget surplus of 4.6% of GDP in fiscal year 1948 fell to 0.2% in fiscal year 1949, as spending went from $29.8 billion in 1948 to $38.8 billion in 1949, as automatic stabilizers kicked in. In fiscal year 1950 (July 1, 1949 to June 30 1950), the budget went into an actual deficit of 1.1% of GDP. Moreover, Congress had pushed through a tax cut in 1948, which boosted private spending in 1949. What we have here is classic Keynesian countercyclical fiscal policy.

Some of the increases from 1950–1953 were, of course, related to the Korean war, but also to new social, welfare and military programs enacted under Truman. Government spending in both absolute terms and as a percentage of GDP surged from 1948 to 1953, fell slightly from 1953–1954 as the Korean war ended, but remained between about 25% and 30% of GDP throughout the classic era of Keynesian economics (1945–1973), as can be seen here:

The various types of economic systems that we know as capitalism are characterised by decentralised decision-making by individual agents under uncertainty and shifting subjective expectations and utilities.

But decisions by a large enough number of people that appear advantageous at the micro level can have negative macro effects.

A perfect analogy is crowd behaviour during stampedes at large events that result in loss of life and injury. Rumour and panic can thrive in large crowds and the macro-effects are disastrous when people are killed or injured in stampedes. From the individual (or micro) perspective it makes sense to leave a crowded event as fast as possible to avoid what might be a treat to your life: when enough people do it the result might not, however, be beneficial to you.

Aggregate variables like investment and macro phenomena like stock markets can be subject to similar problems related to micro versus macro effects. Rumour and panic can cause crashes in financial markets or in investment decisions: negative subjective expectations (with or without rational foundation) can spread to large numbers of business people causing investment and employment to collapse.

Government is akin to the management of a theatre, where theatre managers use their power (through public announcement and their security staff) to prevent disastrous macro events like stampedes. Intervention by theatre management (the analogy to government) to prevent panic and disaster in a theatre (or government stopping secondary deflation and depression in an economy) is a better outcome than allowing large scale micro-behaviour that has terrible macro-effects.

In the case of a slump in investment owing to shocked business expectations, this can take the form of what Keynes called “socialization of investment” (public works and other public spending programs that can be analogous to investment), or increasing people’s spending power to create the demand necessary for increased production.

The PhD is a study with three separate essays dealing with Austrian capital and interest rate theory. In the second essay, Murphy critiques the pure time preference theory of the interest rate (Murphy 2003: 58–126), and, in his third chapter, he supports a view of interest rates as purely monetary phenomena (Murphy 2003: 127–177).

In taking a monetary theory of the interest rate, Murphy is far closer to Keynes than the views of many of his fellow Austrians, and indeed in his blog post above he cites Keynes’ remarks on interest in Chapter 13 of the General Theory with measured approval (Robert P. Murphy, “Is Keynes from Heaven or Hell,” 7 July 2011).

Murphy’s PhD is also worth reading in its own right. Some highlights follow.

On p. 107 (n. 33), Murphy identifies some hypocrisy from Henry Hazlitt, who had condemned Keynes’s concept of “own rates of interest” as a “strange” idea and “nonsense,” even though Rothbard uses a similar concept in his analysis of interest in capital goods markets. Murphy contends that the pure time preference theory of interest rates “encourages exactly the type of thinking that Hazlitt finds so absurd” (Murphy 2003: 107, n. 33).

From pp. 100–107, one can read Murphy’s critique of the idea that a uniform rate of originary interest would arise amongst all individuals and in goods markets.

It is only in the imaginary “evenly rotating economy” (ERE), a stationary general equilibrium with “a world of certainty and unchanging conditions over time” (Murphy 2003: 103), that a uniform rate of originary interest would emerge. In a dynamic general equilibrium the uniform rate need not emerge.

Here Murphy invokes the Hayek–Sraffa exchange, and Ludwig Lachmann’s possible solution to the problem of the unique natural rate:

“What is much less clear to us is to what extent Hayek was aware that by admitting that there might be no single rate he was making a fatal concession to his opponent. If there is a multitude of commodity rates, it is evidently possible for the money rate of interest to be lower than some but higher than others. What, then, becomes of monetary equilibrium?” (Lachmann 1994: 154).

“It is not difficult, however, to close this particular breach in the Austrian rampart. In a barter economy with free competition commodity arbitrage would tend to establish an overall equilibrium rate of interest. Otherwise, if the wheat rate were the highest and the barley rate the lowest of interest rates, it would be profitable to borrow in barley and lend in wheat. Inter-market arbitrage will tend to establish an overall equilibrium in the loan market such that, in terms of a third commodity serving as numéraire, say steel, it is no more profitable to lend in wheat than in barley. This does not mean that actual own-rates must all be equal, but that their disparities are exactly offset by disparities between forward prices. The case is exactly parallel to the way in which international arbitrage produces equilibrium in the international money market, where differences in local interest rates are offset by disparities in forward rates” (Lachmann 1994: 154).

Murphy rejects Lachmann solution:

“Lachmann is defending Hayek from Sraffa’s claim that there is no reason for a unique ‘natural rate of interest.’ But Sraffa’s whole point was that there are, in principle, just as many natural rates as commodities; the fact that the rates in terms of any one commodity, such as steel, must be equal does not rescue Hayek. (One cannot explain the trade cycle as a deviation of the money rate of interest from ‘the’ natural rate of interest if the rate calculated in terms of steel is different from the natural rate calculated in terms of copper.) … arbitraging alone will not establish a unique real rate of interest in the way Lachmann seems to think.” (Murphy 2003: 102, n. 27).

According to Murphy, arbitrage would not lead to equalization of natural rates. As far as I can see, Murphy does not explore the consequences of this for the Hayekian versions of the Austrian trade cycle theory: if there is no unique natural rate of interest or tendency for such a unique rate, what becomes of the theory? This was the point of Sraffa’s critique of Hayek’s Prices and Production (Sraffa 1932a and 1932b).

Murphy concludes that interest is “quite simply the price of borrowing money or (what is the same thing) the exchange rate of present versus future money units” (Murphy 2003: 176).

One can find the relevant passage in Lachmann’s short essay Macro-economic Thinking and the Market Economy: An Essay on the Neglect of the Micro-Foundations and its Consequences (1973), which is worth reading in its own right.

Lachmann comments on the nature of aggregates towards the end of his essay, and states:

“Aggregates, such as gross domestic product or gross investment in manufacturing industries, are therefore not to be regarded as magnitudes which would or could remain constant but for growth. Their composition is undergoing continuous change affecting their total magnitude. Growth of the aggregates is always the cumulative result of other changes in quantities of resources and factor productivity, in relative prices and demand, and so on. Only in a one-commodity world could it be otherwise. It is therefore impossible to discuss meaningfully policy measures designed to affect the magnitude of such aggregates without also discussing those changes in their composition which must accompany them.

Perhaps an historical example will elucidate what we mean. Policies based on Keynesian macro-economic recipes might have succeeded (had they then been tried) in 1932 and did succeed in 1940 because it so happened that at the bottom of the Great Depression as well as during the Second World War all sectors of the economy were equally affected. In 1932 any kind of additional spending on whatever kind of goods would have had a favourable effect on incomes because there was unemployment everywhere, as well as idle capital equipment and surplus stocks of raw materials. During the war the situation was exactly the opposite, but precisely for this reason the same recipes, but with opposite sign, applied. With millions of men and women in the armed forces everything, not merely labour, was scarce and any reduction in demand anywhere welcome.

These are, of course, abnormal situations. Normally in an industrial economy we find some declining industries (coal mining, cinemas) side by side with rapidly expanding ones. Problems arising here require detailed study and are resistant to macro-economic panaceas.” (Lachmann 1973: 50).

In conditions of severe unemployment, idle capital equipment (what we would now call low capacity utilization), and surplus stocks of raw materials, according to Lachmann, we have reason to believe that Keynesian policies will work.

It seems to me that, although capacity utilization has risen from less than 70% in the depth of the US recession in 2009 to 76% in 2011, these factors still apply to the US economy: mass unemployment and space for increased production. The US can also import raw materials and other commodities needed for expansion, and this would help growth in the rest of the world. The US is in much the same state now as it was in 1935: a recovery owing to fiscal stimulus, but not enough stimulus for full employment.

BIBLIOGRAPHY

Lachmann, L. M. 1973. Macro-economic Thinking and the Market Economy: An Essay on the Neglect of the Micro-Foundations and its Consequences, Institute of Economic Affairs.

Saturday, July 9, 2011

The use of equilibrium in the sense of Keynes’s expression “unemployment equilibrium” is potentially confusing. Keynes does not use the word “equilibrium” here in the sense of a static system where nothing changes:

“Keynes used the ‘rest’ definition of equilibrium only with respect to employment, and this did not preclude the possibility of money-wage rates and prices changing in such a situation, as long as these changes do not have any clear effect on the level of employment. Patinkin (1965: 315) used a definition of equilibrium that referred not only to one dependent variable but to the economic system as a whole: ‘“equilibrium” means that nothing tends to change in the system.’ According to this definition, Keynes’s unemployment equilibrium is a position of ‘disequilibrium’ because of the consequent changes in the values of other variables. Patinkin was aware of the implicit definition used by Keynes. ‘All, then, that Keynes means by the statement that the system may settle down to a position of “unemployment equilibrium” is that the automatic workings of the system will not restore the system to a position of full-employment equilibrium. He does not mean “equilibrium” in the usual sense of the term that nothing tends to change in the system’ (643). Leijonhufvud (1969: 22n) also interprets Keynes’s ‘unemployment equilibrium’ as implying the weakness of the forces ‘tending to bring the system back to full employment.’” (Asimakopulos 1991: 27, n. 3)

Keynes’s view was that real-world capitalist systems have a tendency to fluctuate around a state well below full employment:

“our actual experience … [sc. is] that we oscillate, avoiding the gravest extremes of fluctuation in employment and in prices in both directions, round an intermediate position appreciably below full employment and appreciably above the minimum employment a decline below which would endanger life.” (Keynes 2008 [1936]: 229).

I have recently read this interesting passage in a book by Gene Callahan:

“Because of his focus on uncertainty, Lachmann came to doubt that, in a laissez-faire society, entrepreneurs would be able to achieve any consistent meshing of their plans. The economy, instead of possessing a tendency toward equilibrium, was instead likely to careen out of control at any time. Lachmann thought that the government had a role to play in stabilizing the economic system and increasing the coordination of entrepreneurial plans. We call his position ‘intervention for stability.’”(Callahan 2004: 293).

The question immediately arises: what government interventions did Lachmann support?

I have yet to find passages in Lachmann’s writings that support government interventions “for stability.” Lachmann appears to have accepted a small state, as in Mises’s Classical liberal conception of government:

“[sc. Lachmann thought that] … government intervention in economic affairs should be minimal. The role of government should be as circumscribed as possible and conform to the classical liberal ideal of supporting the free market by strengthening the institutions of private property and voluntary business contract.” (Grinder 1977: 22).

Perhaps Lachmann’s idea of interventions for stability refers to the admission by some Austrians that an economy can suffer a “secondary deflation” that will plunge it into unnecessary suffering, and that some kind of monetary stabilisation is required.

This appears to have been Hayek’s position late in life, as he retreated from his liquidationist extremism:

“Although I do not regard deflation as the original cause of a decline in business activity [sc. after 1929], such a reaction has unquestionably the tendency to induce a process of deflation – to cause what more than 40 years ago I called a ‘secondary deflation’ – the effect of which may be worse, and in the 1930s certainly was worse, than what the original cause of the reaction made necessary, and which has no steering function to perform. I must confess that forty years ago I argued differently. I have since altered my opinion – not about the theoretical explanation of the events, but about the practical possibility of removing the obstacles to the functioning of the system in a particular way” (Hayek 1978: 206).

In saying this, Hayek presumably would have accepted a monetarist solution of stabilizing the money supply by open market operations and other interventions.

The effects of “secondary deflation” are also acknowledged by Roger Garrison:

“Deflation caused by a severe monetary contraction is another matter. Strong downward pressures on prices in general put undue burdens on market mechanisms. Unless, implausibly, all prices and wages adjust instantaneously to the lower money supply, output levels will fall. Monetary contraction could be the root cause of a downturn - as, for instance, it seems to have been in the 1936–7 episode in the USA. The Federal Reserve, failing to understand the significance of the excess reserves held by commercial banks, dramatically increased reserve requirements, causing the money supply to plummet as banks rebuilt their cushion of free reserves. But what caused the money supply to fall at the end of the 1920s boom? The monetarists attribute the monetary contraction to the inherent ineptness of the central bank or to the central bank’s (ill-conceived) attempt to end the speculative orgy in the stock market, an orgy that itself goes unexplained. In the context of Austrian business cycle theory, the collapse in the money supply is a complicating factor rather than the root cause of the downturn. In 1929, when the economy was in the final throes of a credit-induced boom, the Federal Reserve, uncertain about just what to do and hampered by internal conflict, allowed the money supply to collapse. The negative monetary growth during the period 1929 to 1933 helps to account for the unprecedented depth of the depression.” (Garrison 2005: 515).

“The problem of policy-induced intertemporal discoordination can easily get compounded by a loss of business confidence and/or by a collapse of the banking system. These complicating factors can cause the economy to suffer a general economic contraction.” (Garrison 2002: 249).

A more interesting admission is made by Jesus Huerta de Soto:

“As Austrian economists in general and Mises in particular demonstrated as early as 1928, in the specific event that idle resources and unemployment are widespread, entrepreneurs, relying on new loans, may continue to lengthen the productive structure without provoking the familiar reversion effects, until the moment one of the complementary factors in the production process becomes scarce.66At the very least, this fact shows Keynes’s so-called general theory to be, in the best case, a particular theory, applicable only when the economy is in the deepest stages of a depression with generalized idle capacity in all sectors.”67
….66 Mises, On the Manipulation of Money and Credit, p. 125 (p. 49 of Geldwertstabilisierung und Konjunkturpolitik, the German edition).

67 For Roger Garrison, the true general theory is that of the Austrians and “Keynesian theory [we would also say monetarist theory] becomes a special case of Austrian theory.” See Garrison, Time and Money, p. 250.

(Huerta de Soto 2006: 553).

Of course, Huerta de Soto then goes on to deny that government intervention will work in such circumstances, but the concession that he attributes to Garrison - that Keynes’ theory might work “when the economy is in the deepest stages of a depression with generalized idle capacity in all sectors” - is quite an admission. What else was the Great Depression?

To return to Lachmann, I am curious to know if other people have read anything of Lachmann’s arguments for government interventions “for stability.”

Sunday, July 3, 2011

Bertrand Russell (1872–1970) was about 10 years older than Keynes, and attended Cambridge in the 1890s in the decade before Keynes began his undergraduate degree at King’s College in 1902. Russell’s opinion of Keynes is found in his Autobiography (Russell 2000: 67–69), and is of historical interest:

“The tone of the generation some ten years junior to my own was set mainly by Lytton Strachey and Keynes. It is surprising how great a change in mental climate those ten years had brought. We were still Victorian; they were Edwardian. We believed in ordered progress by means of politics and free discussion. The more self-confident among us may have hoped to be leaders of the multitude, but none of us wished to be divorced from it. The generation of Keynes and Lytton did not seek to preserve any kinship with the Philistine. They aimed rather at a life of retirement among fine shades and nice feelings, and conceived of the good as consisting in the passionate mutual admirations of a clique of the elite. This doctrine, quite unfairly, they fathered upon G. E. Moore ....” (Russell 2000: 67).

“From this atmosphere Keynes escaped into the great world, but Strachey never escaped. Keynes’s escape, however, was not complete. He went about the world carrying with him everywhere a feeling of the bishop in partibus. True salvation was elsewhere, among the faithful at Cambridge. When he concerned himself with politics and economics he left his soul at home. This is the reason for a certain hard, glittering, inhuman quality in most of his writing. There was one great exception, The Economic Consequences of the Peace, ....” (Russell 2000: 68).

“Keynes’s intellect was the sharpest and clearest that I have ever known. When I argued with him, I felt that I took my life in my hands, and I seldom emerged without feeling something of a fool. I was sometimes inclined to feel that so much cleverness must be incompatible with depth, but I do not think that this feeling was justified.” (Russell 2000: 69).

Saturday, July 2, 2011

(1) on neoclassical general equilibrium theory,
(2) demand curves;
(3) how macroeconomics is an emergent property, which is not reducible to microeconomics;
(4) how neoclassical economics commits the fallacy of strong reductionism (although reductionism does work to a very great extent, it sometimes has limitations);
(5) how rational expectations (in the sense of John Muth) is nonsense, and
(6) a monetary theory for the real world.

One of the more interesting points is Keen’s attacks on the law of demand, and the question whether market demand curves do in fact obey the law of demand. That demand curves are necessarily downward sloping is a fundamental assumption of the law of demand, i.e., when the price of a commodity rises, ceteris paribus (“all else held constant” or “all other things being equal”), the quantity demanded falls, and when the price of a commodity falls, consumers demand more of the commodity. This inverse (or negative) relationship is the law of demand. But Keen shows that demand curves are not necessarily downward sloping:

“Economists can prove that ‘the demand curve slopes downward in price’ for a single individual and a single commodity. But in a society consisting of many different individuals with many different commodities, the ‘market demand curve’ is more probably jagged, and slopes every which way. One essential building block of the economic analysis of markets, the demand curve, therefore does not have the characteristics needed for economic theory to be internally consistent.” (Keen 2001: 25).

That is a problem not just for neoclassical economics but for Austrian economics too, as Mark Blaug has argued:

“[sc. there is a] the fundamental flaw in Ludwig von Mises’ ‘praxeology’: [sc. it is] the notion that purposive choice as a Kantian ‘a priori synthetic proposition’ is more than sufficient to account for negatively inclined demand curves. This ignores the fact that a number of a posteriori auxiliary propositions are also required, such as transitivity or consistency of choices ... To this day, this failure to recognize the limited power of a priori synthetic propositions to generate substantive implications for economic behaviour characterises neo-Austrian writings in defence of Mises” (Blaug 1994: 132–133, n. 14; see also Blaug 1997: 332ff.).

Keen has a new edition of his Post Keynesian book on economics, which will be published September 2011:

Friday, July 1, 2011

Hayek and Keynes undoubtedly had deeply conflicting, and at times mutually hostile, views on economics. Their personal relationship, however, was not so bad, as Skidelsky has noted:

“[Keynes] had no personal animus against ... [Hayek], ‘Hayek has been here for the weekend,’ Keynes wrote to Lydia on 5 March 1933. ‘I sat by him in hall last night and lunched with him at Piero’s to-day. We get on very well in private life. But what rubbish his theory is – I felt to-day that even he was beginning to disbelieve it himself.’ This seems to have been the last occasion when they discussed economic theory. Thereafter they corresponded amiably enough about their various antiquarian discoveries. Keynes befriended Hayek during the war, and it was he who proposed him for a fellowship of the British Academy in 1944. He made an unforgettable personal impression on Hayek – ‘the magnetism of the brilliant conversationalist with his wide range of interests and bewitching voice.’ But Hayek never ceased to believe that Keynes’s influence on economics was ‘both miraculous and tragic.’ Hayek remained a bystander as the Keynesian Revolution unfolded; and only started to organise a resistance after Keynes’s death.” (Skidelsky 1992: 459).

Hayek’s harsh judgement on Keynes’s economics is reflected in the videos below.

From 1.00 onwards, Hayek dishonestly states that he accurately “predicted” the inflation of the 1970s (or strongly implies so). In fact, he did no such thing: Hayek himself stated elsewhere that his “prediction” of what would happen in the post-war period was wrong in important respects:

“While on the one hand, immediately after the war I never believed, as most of my friends did, in an impending depression, because I anticipated an inflationary boom. My expectation would be that the inflationary boom would last five or six years, as the historical ones had done, forgetting that then the termination was due to the gold standard. If you had no gold standard—if you could continue inflating for much longer—it was very difficult to predict how long it would last. Of course, it has lasted very much longer than I expected.” (Nobel Prize-Winning Economist: Friedrich A. von Hayek, p. 184).

In the second video, Hayek states that he never replied to the General Theory because Keynes was always changing his mind. In fact, Skidelsky responds to this:

“… Hayek later repeatedly claimed that he did not review Keynes’ General Theory because he feared ‘before I had completed my analysis he would have changed his mind.’ More likely, Hayek did not want to expose himself to another mauling from the Keynesians. But the decisive reason, as he himself later suggested, was that ‘my disagreement with that book did not refer so much to any detail of the analysis as to the general approach followed in the whole work. The real issue was the validity of what we now call macroeconomics.” Skidelsky (1992: 459).

Robert Skidelsky in John Maynard Keynes: The Economist as Saviour, 1920–1937 (vol. 2; London, 1992) has a rather curious insight into Hayek’s work on the Austrian trade cycle theory:

“Hayek, like Keynes, hoped to prevent a slump from developing by preventing the credit cycle from starting. But his method was very different. It was to forbid the banks to create credit, something which could be best achieved by adherence to a full gold standard. He was quite pessimistic, though, about this being practical politics, so his conclusion, like Keynes’s, was that a credit-money capitalist system is violently unstable – only with this difference, that nothing could be done about it. One can understand why Hayek’s doctrines attracted a certain kind of socialist: they seemed to reach Marx’s conclusions by a different route. Because of the Austrian school’s close attention to the institutional and political setting of a credit-money economy, Hayek’s picture of the capitalist system in action was altogether more sombre than that of conventional Anglo-Saxon economics, with its story of easy adjustments to ‘shocks.’” (Skidelsky 1992: 457).

Skidelsky is actually right: the Austrian trade cycle theory requires that real world capitalism has been severely flawed for over two centuries, and serious entertainment of the theory also leads to the conclusion that the history of modern capitalism has been nothing but an endless series of unsustainable cycles. Far from being a defence of real world modern capitalism, Austrian theory is radical rejection of and attack on it. When Hayek lectured at the London School of Economics, he was working at an institution that had been founded in 1895 by the Fabian socialists Sidney Webb, Beatrice Webb and George Bernard Shaw. Socialists listening to his lectures might very well have concluded that his theory of the trade cycle was yet another nail in the coffin of capitalism, while rejecting his policy advice of doing nothing.

The Austrian school nevertheless touts itself as the purest of pure defenders of capitalism. But the actual “free markets” and alternative “capitalism” imagined by, say, Rothbardian anarcho-capitalists is a fantasy, Alice-in-Wonderland construct that has never existed in the real world. The Rothbardian vision of capitalism is one where fractional reserve banking, fiduciary media and government would be completely abolished.

But, frankly, one of the secrets of capitalism was its fractional reserve banking (FRB) system, able to expand the money supply endogenously in accordance with demand for credit, and capable of using idle resources. Fiduciary media (or money substitutes) have traditionally been bills of exchange, cheques, demand deposits, and private bank notes. Even cheques and banknotes were used increasingly in the 18th century as the use of actual gold declined. It is estimated that, in some capitalist countries by the beginning of 19th century, bills of exchange were 70% of money in circulation, and the other 30% was paper money and commodity money (Suntum 2004: 74). By contrast, Triffin (1985: 152) estimates that in 1800 bank money or credit money probably constituted less than 33% of the money supply. But by 1913 paper currency and bank deposits accounted for 90% of overall currency circulation in the world, and actual gold itself for not much more than 10%. If this is correct, gold rapidly declined to less than 50% of the money supply in the course of the 19th century. If a bill of exchange was issued and then a bank note issued based on the same gold in a demand deposit, new money was created. Gold came to function merely as a monetary base.

FRB increased commerce, trade and investment very significantly in the 19th century. The intelligent defenders of capitalism (like George Selgin) celebrate FRB, rather than condemn it. Joseph Schumpeter, for example, also realised the genius of the modern credit system:

“In this sense, therefore, we define the kernel of the credit phenomenon in the following manner: credit is essentially the creation of purchasing power for the purpose of transferring it to the entrepreneur, but not simply the transfer of existing purchasing power. The creation of purchasing power characterises, in principle, the method by which development is carried out in a system with private property and division of labour. By credit, entrepreneurs are given access to the social stream of goods before they have acquired the normal claim to it. It temporarily substitutes, as it were, a fiction of this claim for the claim itself. Granting credit in this sense operates as an order on the economic system to accommodate itself to the purposes of the entrepreneur, as an order on the goods which he needs: it means entrusting him with productive forces. It is only thus that economic development could arise from the mere circular flow in perfect equilibrium. And this function constitutes the keystone of the modern credit structure” (Schumpeter 1983 [1934]: 107).

But FRB has both a positive and negative side: when credit is used to fuel asset bubbles and feverish speculation on financial or real asset markets, this in all known cases ends in the collapse of bubbles, and leads frequently to debt deflation, financial system instability, and depression or recession.

The Austrians are in fact divided into two irrational ideological extremes: on the one hand, the anti-FRB Rothbardians condemn the FRB system as immoral and blame it for all business cycles, and, on the other hand, the free banking Austrians defend FRB and labour tirelessly trying to absolve it of all charges that it creates instability. Both are false and ridiculous views.

There is no contradiction is saying that FRB has both great benefits for economic development under some circumstances, but disastrous consequences in other circumstances. The best analogy would be modern drugs: they have marvellous therapeutic value, but when used incorrectly many can kill you.

The solution to the problem of the potential instability of FRB is not to abolish it, but to regulate it, abolish commodity money and provide a lender of last resort in the form of a central bank. Far from being a perversion or distortion of capitalism, these developments were a natural and logical development of the capitalist system to a more efficient and superior form. That is why, I suspect, the mainstream neoclassicals (who are also vehement defenders of capitalism) mostly have no problems with central banking and fiat money.

BIBLIOGRAPHY

Schumpeter, J. A. 1983 [1934]. The Theory of Economic Development: An Inquiry into Profits, Capital, Credit, Interest, and the Business Cycle, Transaction Books, New Brunswick, N.J. and London.

In Money, Bank Credit and Economic Cycles (Auburn, Ala., 2006), Jesus Huerta de Soto attempts to defend the Austrian business cycle theory (ABCT) against the charge that it fails to consider what happens when idle resources are available:

“Critics of the Austrian theory of the business cycle often argue that the theory is based on the assumption of the full employment of resources, and that therefore the existence of idle resources means credit expansion would not necessarily give rise to their widespread malinvestment. However this criticism is completely unfounded. As Ludwig M. Lachmann has insightfully revealed, the Austrian theory of the business cycle does not start from the assumption of full employment. On the contrary, almost from the time Mises began formulating the theory of the cycle, in 1929, he started from the premise that at any time a very significant volume of resources could be idle. In fact Mises demonstrated from the beginning that the unemployment of resources was not only compatible with the theory he had developed, but was actually one of its essential elements.” (Huerta de Soto 2006: 265–508).

But Huerta de Soto has done nothing here but engage in a sleight of hand: the charge against ABCT is that its cycle effects do not occur if the factor inputs and consumer goods required by expanded demand are not scarce. That an economy might not be at full employment and may have idle resources when the money supply is expanded does answer the question of how the cycle effects happen, if the relevant factor inputs continue to remain abundant, either through domestic production through increasing capacity utilization, idle stocks or even by international trade.

Moreover, the claim that “unemployment of resources was not only compatible with … [the trade cycle theory Mises] had developed, but was actually one of its essential elements” is not supported by a reading of Mises. All that Mises does is admit the fact that capitalist economies do have idle resources, but then says that his cycle effects require that this abundance declines and the relevant factor inputs become scarce. In “Monetary Stabilization and Cyclical Policy” (1928) Mises has the following to say:

“Since it always requires some time for the market to reach full ‘equilibrium,’ the ‘static’ or ‘natural’ prices, wage rates and interest rates never actually appear. The process leading to their establishment is never completed before changes occur which once again indicate a new ‘equilibrium.’ At times, even on the unhampered market, there are some unemployed workers, unsold consumers’ goods and quantities of unused factors of production, which would not exist under ‘static equilibrium.’ With the revival of business and productive activity, these reserves are in demand right away. However, once they are gone, the increase in the supply of fiduciary media necessarily leads to disturbances of a special kind. In a given economic situation, the opportunities for production, which may actually be carried out, are limited by the supply of capital goods available. Roundabout methods of production can be adopted only so far as the means for subsistence exist to maintain the workers during the entire period of the expanded process. All those projects, for the completion of which means are not available, must be left uncompleted, even though they may appear technically feasible—that is, if one disregards the supply of capital. However, such businesses, because of the lower loan rate offered by the banks, appear for the moment to be profitable and are, therefore, initiated. However, the existing resources are insufficient. Sooner or later this must become evident. Then it will become apparent that production has gone astray, that plans were drawn up in excess of the economic means available, that speculation, i.e., activity aimed at the provision of future goods, was misdirected.” (Mises 2006 [1978]: 110).

With respect to Hayek’s presentation of the Austrian trade cycle theory in Prices and Production, the evidence does not support Huerta de Soto either. Hayek explicitly conceded that he had assumed full employment in Prices and Production (1931):

“As it is sometimes alleged that the ‘Austrians’ were unaware of the fact that the effect of an expansion of credit will be different according as there are unemployed resources available or not, the following passage from Professor Mises’ Geldwertstabilisierung und Konjunkturpolitik (1928, p. 49) perhaps deserves to be quoted: ‘Even on an unimpeded market there will be at times certain quantities of unsold commodities which exceed the stocks that would be held under static conditions, of unused productive plant, and of unused workmen. The increased activity will at first bring about a mobilisation of these reserves. Once they have been absorbed the increase of the means of circulation must, however, cause disturbances of a peculiar kind.’ In Prices and Production, where I started explicitly from an assumed equilibrium position, I had, of course, no occasion to deal with these problems. (Hayek 1975 [1939]: 42, n. 1).

There is no way to deny this fact. The starting point in Prices and Production was in fact the assumption of an economy in full employment equilibrium.

In Monetary Theory and the Trade Cycle (1929) [English trans. 1933 by N. Kaldor and H.M. Croome]), Hayek had also made it perfectly clear full employment equilibrium was his starting point:

“The purpose of the foregoing chapter was to show that only the assumption of primary monetary changes can fulfill the fundamentally necessary condition of any theoretical explanation of cyclical fluctuations—a condition not fulfilled by any theory based exclusively on “real” processes. If this is true then at the outset of theoretical exposition, those monetary processes must be recognized as decisive causes. For we can gain a theoretically unexceptionable explanation of complex phenomena only by first assuming the full activity of the elementary economic interconnections as shown by the equilibrium theory, and then introducing, consciously and successively, just those elements that are capable of relaxing these rigid interrelationships.” (Hayek 2008: 47).

The assumption of “full activity of the elementary economic interconnections as shown by the equilibrium theory” is nothing but a static equilibrium assumption of full employment.

In a letter written to John Hicks in 1967, Hayek confirms that his theory required the assumption of full employment at the beginning of the process:

“Hicks to Hayek, November 27, 1967
...
We have (a) full employment, (b) static expectations, (c) ‘equilibrium’ at every stage, so that demand = supply in every market, prices being determined by current demand and supply. Add to these the Wicksell assumption, of a pure credit economy and we clearly find that if there were in lags, the market rate of interest cannot be reduced below the natural rate in an equilibrium position; ...